Ernst & Young and Ernst & Young, LLP (collectively, "Ernst &
Young") appeal from a judgment of the United States Bankruptcy
Court (Burton R. Lifland, Judge) in an adversary proceeding. The
bankruptcy court found Ernst & Young liable for breach of
contract, negligence, negligent misrepresentation and fraud in
connection with Ernst & Young's pre-petition auditing of the
financial statements of a company that petitioned for bankruptcy.
The bankruptcy court entered judgment against Ernst & Young for
approximately $70 million, and expunged Ernst & Young's $210,850
Proof of Claim against the company.

For the reasons set forth below, the Court affirms in part and
reverses in part the decision of the bankruptcy court. The Court
does not now remand this action to the bankruptcy court, but
rather orders the parties to submit additional briefing. I. Factual Background

The following facts are derived from the bankruptcy court's
April 5, 2000 decision regarding liability, see In re CBI
Holding Co., 247 B.R. 341, 364-65 (Bankr. S.D.N.Y. 2000), and
from the record on appeal. The Court takes from the record on
appeal only those facts that are consistent with the bankruptcy
court's findings and that are uncontested by the parties.

Prior to bankruptcy, CBI Holding Company, Inc., in conjunction
with its subsidiaries (collectively, "CBI" or "Debtors"), was a
large wholesale distributor of pharmaceutical products. As a
wholesale distributor, CBI's business was to purchase
pharmaceutical products from manufacturers, and warehouse those
products for delivery to entities such as retail pharmacies and
hospitals. CBI achieved its size during the early 1990s by
pursuing a strategy of growth through acquisition. CBI financed
its acquisitions in two ways.

First, CBI borrowed capital from a bank syndicate through a
series of lending agreements. The lending agreements limited the
amount of money that CBI could borrow, based on a formula
dependent upon the inventory and accounts receivable of each CBI
subsidiary. The greater the inventory and accounts receivable
that conformed to certain eligibility requirements, the more CBI
could borrow, up to specified limits. The lenders ensured CBI's
compliance with the limitations in the lending agreements by
requiring CBI to submit periodic reports detailing earnings,
inventory, and receivables. Second, CBI acquired capital from Trust Company of the West
("TCW"), which invested in CBI in May 1991 and again in April
1993. In May 1991, TCW invested $20 million in CBI, and received
in return $5 million in shares of CBI common stock (48% of all
shares) and $15 million in corporate notes. In April 1993, TCW
invested an additional $750,000 in CBI, and received a note with
a face value in that amount, plus $250,000 worth of shares of
common stock.

As a result of the May 1991 investment, TCW acquired various
rights, which are set forth in a shareholders agreement dated May
31, 1991 (the "Shareholders Agreement"), and a securities
purchase agreement dated May 13, 1991 (the "Securities
Agreement"). Pursuant to the Shareholders Agreement, TCW had the
right to select two of the five members of CBI's board of
directors and one of the three members of the board's audit
committee. CBI's president and CEO, Robert Castello ("Castello"),
held the remaining 52% of shares of CBI common stock. With that
share of ownership, Castello had the right to select the
remaining members of the board of directors and the audit
committee. TCW also received certain contingent rights to take
control of CBI. Pursuant to the Shareholders Agreement, TCW had
the right to take control of CBI in the event of the occurrence
of a "control triggering event." The Shareholders Agreement
defined control triggering events to include (1) a breach of the
earnings to fixed charge ratio specified in the Securities
Agreement, and (2) a failure to pay principal on TCW's corporate
notes, whether such payment was due at maturity or by reason of acceleration. TCW had the right to accelerate payment on its
notes, pursuant to the Securities Agreement, in the event of a
failure by CBI to comply in any material respect with certain
covenants in the Securities Agreement. Those covenants
established the earnings to fixed charge ratio and included a
prohibition against certain transactions, including loans to
CBI's officers.

The compensation agreement between Castello and CBI provided
for a bonus payment for Castello that was tied to CBI's earnings.
Castello received a bonus for fiscal year 1992 that was tied to
fiscal year 1992 earnings. Castello also caused a portion of his
bonus for fiscal year 1993 to be paid to him before it was due.

In fiscal years 1992 and 1993, CBI's management, including
Castello, participated in the misrepresentation of CBI's
inventory, the misrepresentation of the age of certain of CBI's
receivables, and the intentional failure to record certain of
CBI's liabilities.

Ernst & Young was the pre-bankruptcy accounting firm for
Debtors. Ernst & Young issued unqualified audit opinions with
respect to Debtors' financial statements for fiscal years 1992
and 1993. Ernst & Young issued its fiscal year 1992 opinion on
August 6, 1992, and its fiscal year 1993 opinion on October 26,
1993. For each of those years, Ernst & Young's opinions stated,
inter alia, that Ernst & Young conducted its audit in
accordance with Generally Accepted Accounting Standards ("GAAS")
and that, in the opinion of Ernst & Young, the consolidated
financial statements presented fairly, in all material respects,
the financial position of Debtors. In actual fact, the financial statements prepared by
Ernst & Young did not present fairly, in all material respects,
the financial position of Debtors because Ernst & Young did not
detect certain unrecorded liabilities when it performed the
fiscal 1992 and 1993 audits. In March 1994, Ernst & Young
acknowledged that Debtors' 1993 financial statements were
materially inaccurate and withdrew its October 23, 1993 opinion.
Also in March 1994, Ernst & Young commenced additional procedures
related to the financial statements of CBI for fiscal year 1993
(the "re-audit"). Ernst & Young never completed the re-audit
because, in July 1994, CBI directed it to cease all audit-related
activities.

II. Procedural History

A. The Bankruptcy Proceeding

In August 1994, Debtors filed a petition for relief under
Chapter 11 of the Bankruptcy Code. In January 1995, Ernst & Young
filed a Proof of Claim against CBI in those proceedings in the
amount of $210,850 for allegedly unpaid auditing and consulting
services (the "Proof of Claim"). The Proof of Claim states that
the claim "arises from professional services rendered in 1993 and
1994 on behalf of Debtor in connection with the audit of Debtor's
financial statements and other special engagements as described
in the attached Exhibits." (RE 780).*fn1 Those Exhibits are
seven invoices dated between May 12, 1994 and August 5, 1994. In June
1995, the Official Committee of Unsecured Creditors of Debtors
(the "Creditors' Committee") filed an objection to certain claims
filed in Debtors' bankruptcy action, including the claim filed by
Ernst & Young. The objection does not allege malpractice but
states that it is "without prejudice to the Committee's right to
object to the within proofs of claim on other grounds as may be
necessary." (Affirmation of Michael L. Schein, dated October 17,
1996 (filed in 96 Civ. 7969) Ex. E, at 9).

By order dated August 23, 1995, the bankruptcy court confirmed
the First Amended Joint Plan of Reorganization of Creditors'
Committee and Debtors (the "Plan"). In that order, the bankruptcy
court appointed Bankruptcy Services, Inc. ("BSI"), the appellee
in this action, as the disbursing agent of the Plan. The Plan
"provides for the liquidation of all of the Debtors' Assets and
the prosecution of various litigations on behalf of the Debtors
against third parties (other than the TCW Entities) and the
distribution of the net proceeds thereof to the holders of
Allowed Claims in accordance with applicable bankruptcy law and
this Plan." (RE 795). Under the Plan, Debtors granted to BSI,
inter alia, "the right to pursue and prosecute . . . all
adversary proceedings and contested matters pending or thereafter
commenced or filed in the Bankruptcy Court or elsewhere,
including . . . any and all objections to claims." (RE 798). The
Plan also provided that Debtors "shall be deemed to have waived and released any and all
claims . . . against TCW," and that TCW "shall receive an
[allowed claim] of $16.7 million," and shall "be deemed to have
transferred and assigned to the Disbursing Agent, any and all
rights to pursue and prosecute causes of action of any kind held
by TCW against any third party, in its capacity as a Creditor or
equity security holder of any of the Debtors." (RE 798a).

B. The Adversary Proceeding

On October 16, 1996, BSI, in its capacity as the Disbursing
Agent under the Plan, filed a complaint in bankruptcy court
against Ernst & Young (the "Adversary Proceeding"). On October
25, 1996, the Creditors' Committee and BSI entered into an
assignment under which the Creditors' Committee expressly
assigned to BSI its "right, title and interest to pursue and
prosecute all adversary proceedings and contested matters pending
as of the Effective Date of the Plan or thereafter commenced or
filed in the Bankruptcy Court or elsewhere including, without
limitation, the Litigations and objections to claims, inclusive
of the Objection to the claim of [Ernst & Young]."

On or about October 25, 1996, BSI filed an amended complaint,
alleging the assignment of Debtors' and TCW's claims against
Ernst & Young, and the assignment of the Creditors' Committee's
Objection to Ernst & Young's Proof of Claim. The amended
complaint concerns professional services rendered by Ernst &
Young to Debtors from 1992 to 1994. Specifically, BSI alleges:
(1) breach of contract in connection with the fiscal 1992 and 1993 audits; (2) negligence
in connection with the fiscal 1992 and 1993 audits; (3) negligent
misrepresentation that the fiscal year 1992 and 1993 financial
statements were materially accurate and that Ernst & Young
conducted the fiscal 1992 and 1993 audits in compliance with
GAAS; (4) fraud and/or recklessness in connection with the fiscal
1992 and 1993 audits; (5) fraud and/or recklessness in inducing
Debtors to retain Ernst & Young to perform the reaudit; (6)
breach of fiduciary duty in failing to make certain disclosures
to CBI; and (7) expungement of Ernst & Young's $210,850 Proof of
Claim. BSI brought each of these claims as assignee of the claims
of Debtors. Had CBI not filed for bankruptcy, the claims of
Debtors would belong to Castello (52% shareholder) and to TCW as
an equity holder in CBI (48% shareholder). The Court refers to
these claims as "CBI's claims." The second, third, fourth, and
fifth claims are also brought by BSI as assignee of the claims of
TCW as a creditor of CBI. The Court refers to these claims as
"TCW's claims." The bankruptcy court dismissed the breach of
fiduciary duty claim by order dated April 21, 1999.

In the amended complaint, BSI alleges damages to CBI in the
form of expenditures that would not have been made but for Ernst
& Young's misconduct (e.g., Castello's bonuses and base salary,
fees for certain acquisitions, and fees paid to Ernst & Young),
the loss of Debtors' value as a going concern, and increased
losses and/or liabilities incurred after fiscal year 1992. BSI
alleges damages to TCW representing TCW's loss with respect to
its equity interest in Debtors and its loss with respect to its $15 million note.

Soon after the filing of BSI's amended complaint, Ernst & Young
moved to withdraw the Adversary Proceeding from bankruptcy court
to this Court. By order dated November 13, 1998 (the "1998
Order", the Court denied that motion, concluding that the
Adversary Proceeding qualified as a "core" proceeding under
28 U.S.C. § 157(b)(2), and specifically as a "counterclaim" under §
157(b) 2) (C) and as a proceeding concerning the "allowance or
disallowance of claims against the estate" under § 157(b)(2)
(B).*fn2 See 1998 Order, 6-10. The Court based that
conclusion on its determination that the Proof of Claim and the
claims in the amended complaint "are related, arise out of the
same transaction, and a determination of [BSI's] claims would
likely be dispositive of [Ernst & Young's] claims." Id. at 7.
The Court also held that the interests of judicial economy would
be best served by leaving the adversary proceeding in the
bankruptcy court, given Judge Lifland's familiarity with the
issues and the parties. See id. at 11-12.

In December 1998, Ernst & Young moved for reargument and
reconsideration of the 1998 Order. While that motion was pending,
two other orders relevant to this appeal were issued. First, the
bankruptcy court issued an order in May 1999 that, inter
alia, bifurcated the trial on liability from the determination
of damages. Second, in June 1999, Judge Baer, acting in Part I on an
application by Ernst & Young, issued an order to show cause that
the reference to bankruptcy court for purposes of trial should
not be withdrawn. By order dated July 1, 1999, this Court vacated
the order to show cause and stated that it would consider Ernst &
Young's arguments in support of the order to show cause in
conjunction with Ernst & Young's motion for reconsideration.

The Court denied Ernst & Young's motion for reconsideration, by
order dated August 13, 1999 (the "1999 Order"). In the 1999
Order, the Court rejected Ernst & Young's argument that the
bankruptcy court could not properly hear the claims between TCW
and Ernst & Young because they are two, non-debtor, third
parties. See 1999 Order, 3-4. The Court determined that,
because all of the claims asserted by BSI, including those
assigned to it by TCW, involved Debtors or Debtors' property,
those claims were properly deemed to be core. See id. The
Court also affirmed its earlier finding, made in the 1998 Order,
that BSI's claims constitute counterclaims to Ernst & Young's
Proof of Claim, and rejected Ernst & Young's claim that the
Creditors' Committee's assignment was ineffective. Id. at 4-5.
Finally, the Court concluded that, to the extent the parties were
protected by the Seventh Amendment, the bankruptcy court could
conduct a jury trial without the consent of the partes. Id. at
6-10. The Court did not rule on whether CBI's claims could be
tried without a jury.

By order dated September 3, 1999, the bankruptcy court struck Ernst & Young's jury trial demand, finding that Ernst & Young had
no right to a jury trial.

After a bench trial on the issue of liability, the bankruptcy
court issued its April 5, 2000 decision and granted "judgment"
for CBI "on all remaining counts." In re CBI Holding, 247
B.R. at 369. The bankruptcy court did not discuss separately each
of CBI's six claims and each of TCW's four claims, but instead
stated the following conclusions: (1) Ernst & Young departed from
GAAS in conducting the fiscal year 1992 and 1993 audits of
Debtors' financial statements; (2) Ernst & Young's departure from
GAAS was the proximate cause of injury to CBI and TCW; (3) the
fact that the accounting fraud was known by Castello and other
management employees does not deprive CBI (and BSI acting on
CBI's behalf) of standing to assert its claims of auditor
malpractice; (4) TCW (and BSI acting on TCW's behalf) has
standing to assert both negligence and fraud claims against Ernst
& Young; and (5) TCW's claims are not barred by New York General
Obligation Law section 15-108(c). In its April 5, 2000 decision,
the bankruptcy court did not state any specific conclusion with
respect to BSI's claim for expungement of Ernst & Young's Proof
of Claim.

By order dated April 18, 2000, the bankruptcy court stated
specifically that it had found Ernst & Young liable to BSI on
BSI's first through fifth claims, and scheduled trial on damages.
After a second bench trial, the bankruptcy court determined
damages of $27,738,603, plus pre-judgment interest of over
$17,000,000, with respect to the claims brought by BSI on behalf of CBI, and
damages of $15,412,000, plus pre-judgment interest of nearly
$10,000,000, with respect to the claims brought by BSI on behalf
of TCW. The bankruptcy court found that the appropriate measure
of damages suffered by CBI is the difference in the amount for
which CBI's equity could have been sold in 1993 and $0 (CBI's
value at the time the Plan was entered on August 23, 1995). The
bankruptcy court found that the appropriate measure of damages
suffered by TCW is the amount TCW would have received on its
$15.75 million in notes if CBI had been sold in October 1993. The
bankruptcy court thus awarded damages to TCW only as a creditor
and not as an equity security holder of CBI.

In its final judgment in this action, dated November 6, 2000,
the bankruptcy court stated that, in its April 5, 2000 decision,
it "found [Ernst & Young] liable to [BSI] on each of Counts I
through V and found that with respect to Count VII that [sic]
[Ernst & Young's] proof of claim in the bankruptcy proceeding in
the amount of $210,850 should be expunged." The bankruptcy court
again did not explain its reasons for expunging the Proof of
Claim.

Ernst & Young now appeals the bankruptcy court's decisions
concerning liability and damages.

III. Discussion

In exercising appellate jurisdiction, a district court reviews
the bankruptcy court's findings of fact for clear error, and its conclusions of law de novo. A court reviews mixed questions
of fact and law de novo. See In re Vebeliunas,
332 F.3d 85, 90 (2d Cir. 2003); In re AroChem Corp., 176 F.3d 610,
620 (2d Cir. 1999).

Ernst & Young raises seven arguments on appeal. First, it
renews its argument that BSI's claims are not "core" and thus
were not properly within the jurisdiction of the bankruptcy
court. Second, it argues that it is constitutionally entitled to
a jury trial on BSI's claims against it and that the bankruptcy
court improperly struck Ernst & Young's jury trial demand Third,
it contends that the bankruptcy court erred in refusing to impute
the wrongdoing of CBI's senior management to CBI. Fourth, it
asserts that the bankruptcy court erred in finding that Ernst &
Young's alleged malpractice was the legal cause of CBI's and
TCW's asserted injuries. Fifth, it challenges the bankruptcy
court's findings of negligence and fraud. Sixth, it argues that
TCW's claims are barred by New York statute and by TCW not having
been in privity with Ernst & Young. And, seventh, it argues that
the bankruptcy court erred in its determination of damages.

A. The Court's Determination that BSI's Claims are Core

The Court has twice ruled that BSI's claims against Ernst &
Young are "core" proceedings under the Bankruptcy Code that can
be determined by a bankruptcy judge. See 28 U.S.C. § 157 (b)
(1). Ernst & Young does not reargue the jurisdictional issue in
this appeal but states its continued objection to the Court's
conclusion, and offers to provide plenary argument if the Court decides to revisit the issue. Ernst & Young also sets forth the
principal bases for its position that a bankruptcy judge had no
jurisdiction to try either the CBI claims or the TCW claims.

The Court declines to entertain a complete reargument of the
jurisdictional issue. The Court does, however, take this
opportunity to reiterate and further explain its reasons for
determining that the CBI claims and the TCW claims are core.

Section 157 of the Bankruptcy Code divides claims in bankruptcy
proceedings into two principal categories, "core" and "non-core."
See In re S.G. Phillips Constructors, Inc., 45 F.3d 702,
704 (2d Cir. 1995). "Bankruptcy judges may hear and determine all
cases under title 11 and all core proceedings arising under title
11 or arising in a case under title 11 . . ., and may enter
appropriate orders and judgments, subject to review under section
158 of [title 28]." 28 U.S.C. § 157 (b)(1). Bankruptcy judges may
hear non-core proceedings "that [are] otherwise related to a case
under title 11" but, absent consent of the parties, may only
recommend findings of fact and conclusions of law, which are
subject to de novo review by a district court.
28 U.S.C. § 157(c).

The distinction between core and non-core proceedings derives
from the Supreme Court's decision in Northern Pipeline
Construction Co. v. Marathon Pipe Line Co., 459 U.S. 50 (1982).
See In re United States Lines, Inc., 197 F.3d 631, 636 (2d
Cir. 1999). In Marathon, the Supreme Court struck down portions
of the 1978 Bankruptcy Act and held that only Article III judges
can adjudicate Legal disputes that are not "at the core of the federal
bankruptcy power." 459 U.S. at 71. The Supreme Court ruled
specifically that Congress could not constitutionally give a
bankruptcy court "the authority to adjudicate a state
breach-of-contract action, based on a pre-petition contract,
brought by a debtor against a defendant that had not filed a
claim with the bankruptcy court." In re Orion Pictures Corp.,
4 F.3d 1095, 1100 (2d Cir. 1993).

Congress enacted 28 U.S.C. § 157 in response to Marathon.
Section 157 provides a non-exclusive list of core proceedings,
which includes, inter alia, matters concerning the
administration of the estate, allowance or disallowance of claims
against the estate, counterclaims by the estate against persons
filing claims against the estate, and other proceedings affecting
the liquidation of the assets of the estate or the adjustment of
the debtor-creditor relationship. Both the Second Circuit and the
Supreme Court "have concluded that the Marathon holding was a
narrow one and have broadly construed the jurisdictional grant"
in 28 U.S.C. § 157. In re S.G. Phillips Constructors, Inc.,
45 F.3d at 705. "`[C]ore proceedings' should be given a broad
interpretation that is `close to or congruent with constitutional
limits.'" In re United States Lines, Inc., 197 F.3d at 637
(quoting In re Best Prods. Co., 68 F.3d 26, 31 (2d Cir. 1995)
(quoting In re Arnold Print Works, Inc., 815 F.2d 165, 168
(1st Cir. 1987))). However, "[a] general rule that . . .
proceedings are core [simply] because they involve the property
of the estate would `create[] an exception to Marathon that would swallow the rule.'" In re
United States Lines, Inc., 197 F.3d at 637 (quoting In re
Orion Pictures Corp., 4 F.3d at 1102).

In the context of evaluating whether contract*fn3 actions
are core proceedings, the Second Circuit has stated that the
determination depends on "(1) whether the contract is antecedent
to the reorganization petition; and (2) the degree to which the
proceeding is independent of the reorganization." In re United
States Lines, Inc., 197 F.3d at 637. The fact that an action
arises out of a pre-petition contract weighs against that
proceeding being deemed "core". See In re Petrie Retail,
Inc., 304 F.3d 223, 229 (2d Cir. 2002) (citing In re United
States Lines, Inc., 197 F.3d at 637-38). Similarly, the greater
the degree of independence between the reorganization and a
particular cause of action, the less likely it is that the action
will be deemed core. The degree of independence "hinges on `the
nature of the proceeding.'" In re United States Lines, Inc.,
197 F.3d at 637 (quoting In re S.G. Phillips, 45 F.3d at
707). "Proceedings can be core by virtue of their nature if
either (1) the type of proceeding is unique to or uniquely
affected by the bankruptcy proceedings, or (2) the proceedings
directly affect a core bankruptcy function." In re United
States Lines, Inc., 197 F.3d at 637. In this case, the Court determined that ten claims against
Ernst & Young could be heard by the bankruptcy court, six of
which were pursued on behalf of CBI and four of which were
pursued on behalf of TCW. Nine out of ten of the claims (that is,
all except CBI's expungement claim) are based on events that
occurred before Debtors filed for bankruptcy. That factor cuts
generally against a finding that the claims are core.
Nonetheless, courts commonly find claims to be core based solely
on the nature of the claims, despite the fact that those claims
are based on pre-petition contracts. See, e.g., In re
Petrie Retail, Inc., 304 F.3d at 229-231 (holding that a plan
consummation motion was core, notwithstanding the fact that it
was based on a pre-petition lease); In re United States Lines,
Inc., 197 F.3d at 638 (holding that a contract action was core,
notwithstanding the fact that it was based on pre-petition
contracts). The Court sets forth here a further explanation of
its reasons for deciding that all of the claims in this case are
core.

1. CBI's Claims are Core

CBI's claim for expungement of Ernst & Young's Proof of Claim
is unquestionably core because it directly implicates a core
bankruptcy function, i.e., the allowance or disallowance of
claims against the estate. See 28 U.S.C. § 157 (b)(2)(B); In
re S.G. Phillips, 45 F.3d at 705. CBI's five other claims
(alleging negligence, breach of contract, and fraud) are core
because they are factually and legally interconnected with Ernst
& Young's Proof of Claim and CBI's expungement claim. See In re Iridium
Operating LLC, 285 B.R. at 830-831 (S.D.N.Y. 2002) (claims that
would otherwise be non-core are rendered core because they arise
from the same operative facts as core claims and proofs of claim)
(collecting cases).

The degree to which CBI's negligence, breach of contract, and
fraud claims are interconnected with the Proof of Claim and
expungement claim can be demonstrated by reference to CBI's fraud
claim regarding the reaudit work. As Ernst & Young emphasizes in
its brief on appeal, its Proof of Claim apparently concerned fees
due for services performed in connection with the
reaudit.*fn4 CBI's fraud claim with respect to the reaudit
work specifically alleges that CBI was induced to continue to
retain Ernst & Young to perform the reaudit work under false
pretenses, because Ernst & Young had not revealed its own
culpability in failing to detect Debtors' unrecorded liabilities.
BSI also argues that Ernst & Young's Proof of Claim essentially
charges CBI for Ernst & Young's repetition of audit work that
Ernst & Young performed improperly the first time around. The
Court finds (as it found when it first considered this issue) that such a claim, if proven, could provide a defense to
Ernst & Young's Proof of Claim. See, e.g., Altamore v.
Friedman, 602 N.Y.S.2d 894, 247 (2d Dep't 1993) ("malpractice is
a defense to an action to recover for professional services");
Bowen v. Merdinger, 92 N.Y.S.2d 566, 571 (Sup.Ct. 1949) ("if
by misrepresentation or suppression of facts, the plaintiffs were
induced to enter into the agreement in suit, the agreement is not
only voidable and subject to rescission at the instance of the
injured party, but the defendant has also forfeited all right to
compensation for services rendered").

The Court thus reaffirms its conclusion that CBI's reaudit
fraud claim is core, because it would affect the allowance or
disallowance of Ernst & Young's Proof of Claim, see
28 U.S.C. § 157(b)(2)(B), and states a counterclaim by the estate against a
person filing a claim against the estate, see
28 U.S.C. § 157(b)(2)(C). Because CBI's remaining claims of negligence,
breach of contract, and fraud are based upon the same operative
facts as the reaudit fraud claim and the expungement claim, and
were filed in response to Ernst & Young's Proof of Claim, which
is based on the same set of facts, those claims are also deemed
core. "A response to a proof of claim which is, in essence, a
counterclaim, is a core proceeding under
28 U.S.C. § 157(b)(2)(C)." See In re Baudoin, 981 F.2d 736, 741 (5th
Cir. 1993) (debtor's $4,000,000 contract and tort claims
regarding loans were "core" when creditor filed proof of claim
based on same loans); In re Leslie Fay Cos., No. 97 Civ. 2244 (MGC), 1997 WL 555607, *2 (S.D.N.Y. Sept. 4,
1997) ("The adversary proceeding is nothing more than a
counterclaim by Leslie Fay to the proofs of claim filed by the
Creditors" and is therefore core).

The Court also rejects Ernst & Young's argument that BSI cannot
predicate CBI's claims on § 157(b)(2)(B) (allowance or
disallowance of claims) because neither CBI nor BSI objected to
Ernst & Young's Proof of Claim under the terms of the Plan. The
Court finds that the Creditors' Committee's assignment to BSI of
its objection to Ernst & Young's Proof of Claim was effective, in
light of the nature, purpose, and terms of the Plan.

2. TCW's Claims are Core

TCW's negligence and fraud claims are in a slightly different
posture than CBI's claims. There is no doubt that TCW's claims
are implicated in the claims allowance process to the extent that
those claims are factually congruent with the CBI negligence and
fraud claims that form the basis of CBI's objection to Ernst &
Young's Proof of Claim. However, because Ernst & Young's Proof of
Claim was filed solely against CBI, and not TCW, BSI's claim to
expunge the Proof of Claim is brought on behalf of CBI alone.
TCW's claims cannot, therefore, be core pursuant to § 157(b)(2)
(B), because they would not themselves directly affect the
allowance or disallowance of the Proof of Claim.*fn5 To the
extent the Court did not make this point clear in its previous orders, it does so now.

TCW's claims do, however, qualify as counterclaims by the
estate against persons filing claims against the estate. See
28 U.S.C. § 157 (b)(2)(C). TCW's claims became the property of
Debtors' estate under the Plan. Although the claims were deemed
"transferred and assigned" to BSI, BSI was acting solely as a
disbursing agent for Debtors under the Plan. The assignment to
BSI in these circumstances was equivalent to an assignment to the
estate. This assignment was not effected solely for the purpose
of manufacturing jurisdiction over this adversary proceeding,
cf., In re Maislin Indus, U.S., Inc., 66 B.R. 614, 617
(E.D. Mich. 1986) (denying motion to amend complaint where
assigned claims had no valid business purpose and no clear
relationship to the bankruptcy proceeding), but was effected as
an integral part of the Plan, which was approved by the
bankruptcy court and over which the bankruptcy court retained
jurisdiction. TCW's claims are counterclaims by the estate
arising out of the facts that gave rise to Ernst & Young's Proof
of Claim. In the unique circumstances of this case, the Court
finds that the bankruptcy court had jurisdiction to adjudicate
TCW's claims.*fn6 The case at hand is distinguishable from certain cases in which
courts have found adversary proceedings to be non-core or have
granted motions to withdraw references from the bankruptcy court.
This case is distinguishable from Marathon and In re Orion
Pictures Corp. because Ernst & Young filed a Proof of Claim in
Debtors' bankruptcy proceeding, and BSI's claims are factually
and/or legally related to that Proof of Claim. This case is also
distinguishable from In re Complete Management, Inc., No. 02
CIV. 1736 (NRB), 2002 WL 31163878 (S.D.N.Y. Sept. 27, 2002) and
In re 131 Liquidating Corp., 222 B.R. 209, (S.D.N.Y. 1998),
two decisions in which courts in this district granted motions to
withdraw references from the bankruptcy court.*fn7 B. Ernst & Young's Right to a Jury Trial*fn8

Ernst & Young appeals the bankruptcy court's decision that
Ernst & Young does not have a Seventh Amendment right to a jury
trial. It is well-established that the Seventh Amendment protects
the right to a jury trial only for matters at law, "in
contradistinction" to those in equity. Granfinanciera, S.A. v.
Nordberg, 492 U.S. 33, 41 (1989) (quoting Parsons v. Bedford,
Breedlove & Robeson, 28 U.S. (3 Pet.) 433, 447 (1830) (Story,
J.)). The parties here do not contest that BSI's tort and
contract claims in this action are traditionally legal in nature
and thus that there is ordinarily a right to have them decided by
a jury.*fn9

Legal claims cannot be "`magically converted into equitable
issues' merely because they arise out of [the] equitable
proceedings" of the bankruptcy court. Germain v. Connecticut
Nat'l Bank, 988 F.2d 1323, 1329 (2d Cir. 1993) (quoting Ross v.
Bernhard, 396 U.S. 531, 538 (1970)). In addition, "the
designation of an action as `core' does not control whether or
not the action may be tried before a jury. . . . [t]he
determination that the . . . action is `core' is entitled to
minimal weight in reaching our ultimate decision on the jury trial issue." Germain, 988 F.2d
at 1326. However, certain claims can lose their legal nature, and
be converted into claims in equity, if the action in which the
claims are brought is "integrally related" to the claims
allowance process in bankruptcy. Granfinanciara, 492 U.S. at
60; Germain, 988 F.2d at 1329 & 1332. A claim is integrally
related to the claims allowance process if it affects the
allowance of a creditor's claim filed against the bankruptcy
estate. Id. at 1327.

Because the filing of a claim against the bankruptcy estate
triggers the process of "allowance and disallowance of claims," a
creditor who files such a claim subjects itself to the bankruptcy
court's equitable jurisdiction. Granfinanciera, 492 U.S. at 58.
If that creditor is met with an adversary proceeding, the
resolution of which affects the restructuring of debtor-creditor
and creditor-creditor relations, then the creditor loses its
Seventh Amendment rights, even if the adversary proceeding
concerns traditionally legal claims. Langenkamp v. C.A. Culp,
498 U.S. 42, 44 (1990); Granfinanciera, 492 U.S. at 58-59 & 59
n. 14. If, in contrast, the creditor does not submit a claim
against the bankruptcy estate, it has not subjected itself to the
bankruptcy court's equitable jurisdiction, and it, therefore,
maintains its right to a jury for any claims arising out of the
bankruptcy proceeding. Langenkamp, 498 U.S. at 45;
Granfinanciera, 492 U.S. at 58-59. Accordingly, a creditor's
right to a jury trial on traditionally legal claims arising in an
adversary proceeding depends on: (1) whether the creditor has filed a proof of claim
against the bankruptcy estate, see Langenkamp, 498 U.S. at 45
(quoting Granfinanciera, 492 U.S. at 58); and (2) whether the
resolution of the proceeding affects the allowance of the proof
of claim, see Germain, 988 F.2d at 1327.

Ernst & Young has filed a Proof of Claim against the bankruptcy
estate; its right to a jury trial thus turns on whether the
resolution of BSI's claims affects the allowance of Ernst &
Young's Proof of Claim. To make this determination, the Court
looks again to the relationship between Ernst & Young's Proof of
Claim and the CBI and TCW claims.

1. Ernst & Young Does Not Have a Right to a Jury Trial on
CBI's Claims

The Court finds that the claims assigned to BSI by CBI are
integrally related to the claims allowance process because BSI's
success on those claims would result in the disallowance of Ernst
& Young's Proof of Claim. See id. at 1330, n. 8 (discussing
In re Frost, Inc., 145 B.R. 878, 882 (Bankr. W.D. Mich. 1992)
(debtor's allegations of prepetition attorney malpractice are
"intertwined" with debtor's objection to attorney's proof of
claim for fees due, and thus debtor has no right to jury trial in
adversary proceeding)). The Court has explained above why all of
CBI's claims are integrally related to the allowance of Ernst &
Young's Proof of Claim, and will not repeat that explanation
here. The Court thus finds that the legal issues relevant to
CBI's claims have been "converted to . . . issue[s] of equity"
and that Ernst & Young therefore is not entitled to a jury trial on those issues.
See Billing v. Ravin, Greenberg & Zackin, P.A., 22 F.3d 1242,
1253 (3d Cir. 1994) ("allegation of legal malpractice raised as a
defense to post-petition fees for bankruptcy counsel . . . falls
within the process of the allowance and disallowance of claims
. . . [and] debtors have no Seventh Amendment right to trial by
jury); In re Leslie Faye Cos., 1997 WL 555607, at *2
(adversary proceeding instituted by debtor is essentially an
objection to the allowance of creditors' claims which also seeks
affirmative relief, thus creditors have no right to a jury trial
of adversary proceeding).*fn10

2. Ernst & Young Does Have a Right to a Jury Trial on TCW's
Claims

In contrast to CBI's claims, TCW's claims do not "bear[]
directly on the allowance of [Ernst & Young's] claims."
Germaine, 988 F.2d at 1329. TCW's claims are for money damages
for the alleged, separate and distinct injury sustained by TCW as
a creditor of CBI. These claims are not "integrally related" to
Ernst & Young's Proof of Claim because that Proof of Claim is
against Debtors' bankruptcy estate, not against TCW as a
creditor. Even though success on TCW's claims may augment the size of the
bankruptcy estate, it will not affect BSI's ability to defend
against Ernst & Young's Proof of Claim. See Germain, 988 F.2d
at 1327 ("If [the bankruptcy trustee] wins, the estate is
enlarged, and this may affect the amount the [creditor] and its
fellow creditors ultimately recover on their claims but it has no
effect whatever on the allowance of [the creditor's] claims")
(emphasis in original). BSI cites to no decision, and the Court
has found none, in which a creditor that has filed a proof of
claim against the estate is denied the right to a jury trial on
the claims of a third party creditor. Unlike the claims asserted
by a trustee or other party standing in a debtor's shoes, see,
e.g., Langenkamp, 498 U.S. 42, Granfinanciera, 492 U.S. 33,
and Germain, 988 F.2d 1323, TCW's claims simply do not affect
the allowance of Ernst & Young's Proof of Claim. Accordingly,
Ernst & Young has a Seventh Amendment right to a jury trial on
the claims assigned by TCW in its role as a creditor. It is of no
consequence in determining whether Ernst & Young forfeited its
right to a jury trial on TCW's claims that Ernst & Young
forfeited its right to a jury trial on CBI's claims. Cf.
Kerusa Co. LLC v. W10Z/515 Real Estate Ltd. P'Ship, Nos. 04
Civ. 708 (GEL), 04 Civ. 709 (GEL), 04 Civ. 710 (GEL), 2004 WL
1048239, at *6 (S.D.N.Y. May 7, 2004) (although plaintiffs may
have jeopardized their right to a jury trial against a bankrupt
defendant by filing proofs of claim against the bankrupt's
estate, plaintiffs' right to a jury trial on their claims against
other defendants against whom they had not filed proofs of claim is
unaffected).

The Court has already determined, in the 1999 Order, that the
bankruptcy court has the power to conduct a jury trial. Although
a remand for a jury trial on TCW's claims may "impede swift
resolution of bankruptcy proceedings and increase the expense of
Chapter 11 reorganizations," the Court finds that "`these
considerations are insufficient to overcome the clear command of
the Seventh Amendment.'" Granfinanciera, 492 U.S. at 63 (citing
Curtis v. Loether, 415 U.S. 189, 198 (1974)).

Nevertheless, because Ernst & Young argues that it is entitled
to judgment against both CBI and TCW on various other grounds,
which would negate the need for a new trial on any claims
protected by the Seventh Amendment, the Court turns to Ernst &
Young's other arguments before deciding whether to remand some,
or all, of the claims against Ernst & Young for a jury trial.

C. BSI's Standing

1. Standing to Assert CBI's Claims

BSI asserts claims for fraud, negligence, and breach of
contract, as assignee of the claims of the company (i.e., the
shareholders).

Ernst & Young appeals the bankruptcy court's decision not to
impute the wrongdoing on the part of CBI's management to CBI.
Ernst & Young raises the issue of imputation as part of an in
pari delicto defense. However, because this issue also
affects the determination of BSI's standing to assert CBI's claims, the Court
considers imputation, as a threshold matter, in terms of
standing. See Steel Co. v. Citizens for a Better Environment,
523 U.S. 83, 94-102 (1998) (explaining that an Article III court
cannot decide the meaning or constitutionality of a state or
federal law if the plaintiff does not have standing); see
also Wechsler v. Squadron, Ellenoff, Plesent & Sheinfeld,
LLP, 212 B.R. 34, 36 n. 1 (S.D.N.Y. 1997); In re Mrs.
Weinberg's Kosher Foods, Inc., No. 96 B 44620 (SMB), 2002 WL
1050213, *3 (Bankr. S.D.N.Y. May 28, 2002) ("Some courts view
in pari delicto as a question of standing, while others
treat it as an equitable defense.") (citations omitted). "In
essence the question of standing is whether the litigant is
entitled to have the court decide the merits of the dispute or of
particular issues." Warth v. Seldin, 422 U.S. 490, 498 (1975).
Accord Shearson Lehman Hutton, Inc. v. Wagoner, 944 F.2d 114,
117 (2d Cir. 1991). A party that does not have standing lacks a
"personal stake in the outcome of the controversy" and thus fails
to meet the case or controversy requirement of Article III of the
Constitution. Baker v. Carr, 369 U.S. 186, 204 (1962).

The Bankruptcy Code places a trustee in the shoes of the
bankruptcy estate. Thus, a trustee has standing to bring any suit
that the bankrupt corporation could have brought had the
corporation not filed a petition for bankruptcy. See
11 U.S.C. § 541 & 542; In re Bennett Funding Group, Inc., 336 F.3d 94,
99-100 (2d Cir. 2003) (citing Wagoner, 944 F.2d at 118). In
this appeal, BSI is not a bankruptcy trustee, but it is in a position
analogous to the position of a trustee. Both BSI and the typical
trustee sue in the shoes of the bankrupt's estate. Thus, by
analogy, BSI has standing to institute any suit that Debtors
could have instituted had they not filed a petition for
bankruptcy. See Wight v. BankAmerica Corp., 219 F.3d 79, 80
(2d Cir. 2000) (analogizing the position of the trustee to that
of a party suing on behalf of the debtor); In re Mediators,
Inc., 105 F.3d 822, 826 (2d Cir. 1997) (same).

Whether BSI has standing to assert CBI's claims in contract,
negligence or tort, or whether the right to sue on those claims
belongs to Debtors' creditors, is determined by state law. See
id. at 825. In its April 5, 2000 decision, the bankruptcy court
discussed BSI's standing to raise CBI's claims without
distinguishing the nature of claims. See In re CBI Holding,
247 B.R. at 364-65. The Court here considers BSI's standing to
assert, first, CBI's claims for fraud, second, CBI's claims for
negligence, and, third, CBI's claim for breach of contract.

a. CBI's Fraud Claims

CBI's fraud claims against Ernst & Young relate to Ernst &
Young's (1) fraud and/or recklessness in conducting the fiscal
1992 and 1993 audits, and (2) fraud and/or recklessness in
inducing CBI to retain Ernst & Young to perform the reaudit.
There is no dispute among the parties that members of CBI's
management knew of, purposely did not record, and sought to
conceal from Ernst & Young, certain of CBI's liabilities. See, e.g., RE 107-12, 983 &
1253-54.

In Wagoner, the Second Circuit declared that a "claim against
a third party for defrauding a corporation with the cooperation
of management accrues to creditors, not to the guilty
corporation." Wagoner, 944 F.2d at 120. Accord Wight, 219
F.3d at 86; In re Mediators, 105 F.3d at 826; Hirsch v.
Arthur Andersen & Co., 72 F.3d 1085, 1094 (2d Cir. 1995). Thus,
a bankruptcy trustee, and anyone who similarly stands in the
shoes of the bankrupt corporation, generally does not have
standing to raise those claims. See In re Bennett Funding
Group, 336 F.3d at 99-100.

This rule, which has come to be known as the "Wagoner rule,"
is derived from fundamental principles of agency law. The law of
agency relies on certain presumptions that regulate the
responsibility of a principal for the acts of his agent. The law
of agency presumes that when an agent acquires knowledge while
acting within the scope of his agency, that knowledge will
generally be disclosed to his principal. See Munroe v.
Harriman, 85 F.2d 493, 495 (2d Cir. 1936) ("The presumption of
communication [of the agent's knowledge] is a pure fiction,
contrary to the fact, for it is only when the agent has failed to
communicate his knowledge that any occasion arises for imputing
it to the principal."). The presumption that an agent
communicates such knowledge results from an attempt to balance
factors that favor imputing an agent's knowledge to his principal
(i.e., the principal has control over the agent, the principal
should be incentived to monitor the agent, and the principal chooses to use an agent as
his link to the outside world) and factors that disfavor imputing
the agent's knowledge to his principal (i.e., agency would fall
into desuetude if imputation had no bounds).

It is undisputed that various members of CBI management,
including Castello, committed acts of fraud that were not
discovered by Ernst & Young during its fiscal 1992 and 1993
audits. If the acts of those individuals, and the knowledge of
the fraud possessed by those individuals, can be imputed to CBI
itself, CBI (and, hence, BSI, insofar as BSI stands in CBI's
shoes) lacks standing to sue Ernst & Young for aiding and
abetting the fraud. The acts of fraud will be imputed under the
Wagoner rule, and principles of agency law, unless some
exception to the rule applies.*fn11

i. The "Adverse Interest" Exception

Courts have long recognized an "adverse interest" exception to
the Wagoner rule (the Wagoner rule, as stated above, presumes
that an agent's knowledge will be communicated to his principal,
and thus imputes the agent's knowledge to the principal). The
"adverse interest" exception to Wagoner's rule of imputation
provides that when an agent is "committing a fraud for his own benefit," and
has "totally abandoned" his principal's interest, the acts of the
agent will not be imputed to the principal, and the claim against
a third party for defrauding the corporation will remain with the
corporation, and not be transferred to the creditors. In re
Bennett Funding Group, 336 F.3d at 100 (citing Wight, 219
F.3d at 87). The adverse interest exception is a narrow one; for
it to apply, "the agent must have totally abandoned his
principal's interests and be acting entirely for his own or
another's purposes." Center v. Hampton Affiliates, Inc.,
66 N.Y.2d 782, 784-85 (1985). Accord In re Bennett Funding
Group, 336 F.3d at 100 (citing In re Mediators, 105 F.3d at
827).

The adverse interest exception is entirely consistent with the
principles of agency law explained above. Normally, courts will
impute the knowledge of an agent acting within the scope of his
agency to his principal, because courts presume that such an
agent communicates that knowledge to his principal. The practice
of presuming the transfer of knowledge, and thus imputing the
agent's knowledge to the principal, is a fiction necessitated by
the compromise addressed above. That fiction is untenable,
however, when an agent has totally abandoned the interests of
his principal, and acted entirely in his own or a third party's
interest, because an agent "cannot be presumed to have disclosed
that which would expose and defeat his fraudulent purpose."
Center, 66 N.Y.2d at 784. The bankruptcy court's decision states a number of times that
the segment of management involved in the fraud was acting in its
own interest and not acting in CBI's interest. The bankruptcy
court stated, specifically, that the purpose of the fraud was to
obtain a bigger bonus for Castello, and to preserve Castello's
personal control over CBI. See In re CBI Holding, 247 B.R.
at 365. These statements (made among the bankruptcy court's
findings of law) support the bankruptcy court's conclusion that
the adverse interest exception applies, and that imputation is
therefore inappropriate. However, in its findings of fact, the
bankruptcy court suggested (perhaps inadvertently) that there
existed at least one purpose for the fraud other than to obtain a
bigger bonus for Castello, and to preserve Castello's personal
control over CBI: The bankruptcy court stated in its findings of
fact that "[a] principle [sic] reason why . . . members of
management caused liabilities to remain unrecorded at year-end
was not for any corporate purpose but rather to ensure that
Castello received the maximum bonus and remained in control."
Id. at 360 (emphases added). This language leaves open the
possibility that the bankruptcy court found that some corporate
purpose was served by the fraud. If the Court determines that it
is necessary and appropriate to remand the action to the
bankruptcy court for further proceedings related to CBI's claims,
the bankruptcy court should clarify whether any corporate
purpose was served by the fraud, or whether the corporation's
interests were "totally abandoned" by managers acting "entirely" for their own or
another's interest. Center, 66 N.Y.2d at 785. Accord Wight,
219 F.3d at 87; In re Mediators, 105 F.3d at 827.

The Court notes that whether managers have acted entirely in
their own interests can be difficult to determine in the
corporate setting, where a manager's fortune may depend upon the
corporation's short-term fortune, and thus the manager may
fraudulently manipulate corporate affairs in a way that causes
short-term benefits to accrue to the corporation, for the sole
purpose of receiving higher remuneration himself. Moreover, the
Court is not convinced that the purpose behind management's
conduct should be dispositive of the issue.*fn12
Nevertheless, the Court is bound by New York law as described above.

ii. The So-Called Innocent Insider Exception

The bankruptcy court's decision to apply the adverse interest
exception to CBI's claims was not its primary justification for
declining to impute management's fraudulent conduct to the
company. The primary justification was that at least one
decision-maker among CBI's stockholders (i.e., TCW), and at
least one decision-maker on CBI's board of directors (i.e.,
Frank Pados), were innocent of the fraud, and either would have
taken steps to stop the fraud had the fraud been known. See In
re CBI Holding, 247 B.R. at 365.

In reaching this conclusion, the bankruptcy court appears to
have found applicable a second exception to the Wagoner rule
(i.e., an exception to a presumption of imputation), separate
and apart from the adverse interest exception discussed above.
Some courts have recognized this second exception, and have
referred to it as the "innocent insider" exception. See
Wechsler, 212 B.R. at 36 (Knapp, J.); Breeden v. Kirkpatrick &
Lockhart, LLP, 268 B.R. 704, 710 (S.D.N.Y. 2001) (Sprizzo, J.); BDO Seidman, 49 F. Supp.2d
at 650-51 (Preska, J.); Lippe v. Bairnco Corp., 218 B.R. 294,
302 (S.D.N.Y. 1998) (Chin, J.).*fn13 The innocent insider
exception, as explained by some courts, and as addressed by the
bankruptcy court below, focuses not on whether culpable managers
totally abandoned the company's interest, but rather on whether
some part of management was innocent of the misconduct, unaware
of it, and able to prevent it had the misconduct been known.

The Second Circuit recently discussed the "innocent insider"
exception, but decided not to resolve "the question of whether
the presence of innocent directors would provide the trustee with
standing where fewer than all shareholders are implicated in the
fraud." In re Bennett Funding Group, 336 F.3d at 101.
Instead, the court assumed, arguendo, that such an exception
exists, but concluded that the prerequisites for its application
were absent in the case, because the innocent insiders there were
so impotent that they would have been unable to stop the fraud
even if they had been aware of it. Id.

The rationale behind the innocent insider exception appears to
be that, where only some members of management are guilty of the
misconduct, and the innocent members could and would have
prevented the misconduct had they known of it, the culpability of
the malefactors should not be imputed to the company because that
imputation would punish innocent insiders (e.g., non-culpable
shareholders) unfairly.

This reasoning was rejected by the Seventh Circuit in Cenco,
which stated that where a publicly traded company has delegated
to a board of directors the owners' role of hiring and
supervising managers, and where that board has failed to prevent
managers from committing fraud, the managers' misconduct should
be imputed to the company, so as not to disincentivize the
innocent managers, board members, and owners from policing the
conduct of the guilty. Cenco, 686 F.2d at 454-56. Accord
Restatement (Third) Agency § 5.03 cmt. b (2002) ("Imputation
creates incentives for a principal to choose agents carefully and
to use care in delegating functions to them."). The Court agrees
with Cenco's reasoning, and concludes that misconduct by those
given authority to make decisions on behalf of a company should
be imputed to the company even if innocent members of management
could and would have prevented the fraud had they been aware of
it. The Court, therefore, declines to adopt any innocent insider
exception to the Wagoner rule.*fn14

iii. The Sole Actor Rule and the Innocent Insider Exception

Although the Court rejects the innocent insider exception, the Court nonetheless takes this opportunity to address what appears
to be substantial confusion evidenced by several courts,
including the bankruptcy court below, regarding the nature of the
so-called "innocent insider" exception.

As the Court explained above, the bankruptcy court's decision
in this case to not impute management's misconduct to the company
due to the presence of innocent insiders was made entirely
separately from the bankruptcy court's consideration of the
"adverse interest" exception to the Wagoner rule. That is,
first the bankruptcy court declined to impute management's
misconduct due to the existence of innocent insiders. Then, the
bankruptcy court stated that even if management's wrongdoing
should be imputed to the company, CBI would nonetheless have
standing because the "adverse interest exception" would apply,
given management's apparent total abandonment of the company's
interests. See In re CBI Holding, 247 B.R. at 365. The
Court disagrees with the bankruptcy court's analysis of the
interaction between the Wagoner rule, the adverse interest
exception, and the so-called innocent insider exception.

The key flaw in the analysis is that the primary question to be
addressed when considering the fiction of imputation is whether
the knowledge of the agent that is to be imputed to the principal
was gained within, or outside of, the scope of agency. Even when
an agent is defrauding his principal, unless the agent has
totally abandoned the interests of the principal and is acting
entirely in his own, or another person's, interest, that agent is acting
within the scope of his agency. Thus, unless the adverse interest
exception to the presumption of imputation applies, it is
immaterial whether innocent insiders exists; the agent is still
acting on behalf of the company, and his actions will be imputed
to the company notwithstanding the existence of those innocent
insiders.

When an agent has acted outside of the scope of his agency,
however, his acts will nevertheless be imputed to the principal
"where the principal and agent are one and the same." In re
Bennett Funding Group, 336 F.3d at 100 (citation and quotation
marks omitted). This exception to the adverse interest exception,
styled the "sole actor rule," operates most clearly in the
context of a corporation owned and managed by a single person.
When that person, in his role as a manager, defrauds the
corporation in order to benefit only himself, he has acted
outside of the scope of his agency; technically, the agent's
fraudulent actions should not be imputed to the company pursuant
to the "adverse interest" exception. However, it would be
nonsensical to refrain from imputing the agent's acts of fraud to
the corporation, despite the agent's total abandonment of the
corporation's interests, because the agent is identical to the
corporation. See In re Mediators, 105 F.3d at 827. The same
analysis would apply to a corporation owned and managed by
multiple people, so long as all of them were involved together in
a fraud against the corporation. Where only some of a corporation's owners were involved in a
fraud in their role as managers, courts consider whether those
insiders who were innocent and unaware of the misconduct had
sufficient authority to stop the fraud. See, e.g., In re
Bennett Funding Group, 336 F.3d at 101 (innocent director was
"impotent to actually do anything"); Munroe, 85 F.2d at 495-96
(innocent members of a bank loan committee were dominated by
fraudulent committee member). Cf. Wechsler, 212 B.R. at 36
("the Wagoner rule only applies where all relevant
shareholders and/or decisionmakers are involved in the fraud")
(emphasis added to the word "relevant"). When the innocent
insiders lack authority to stop the fraud, the "sole actor"
exception to the "adverse interest" exception applies, and
imputation is thus proper, because all relevant shareholders
and decisionmakers were involved in the fraud. However, when the
innocent insiders possessed authority to stop the fraud, the
"sole actor rule" does not apply, because the culpable agents who
had totally abandoned the interests of the principal, and were
thus acting outside of the scope of their agency, were not
identical to the principal.

b. CBI's Negligence Claims

CBI's negligence claims against Ernst & Young relate to Ernst &
Young's (1) negligence in connection with the fiscal 1992 and
1993 audits, and (2) negligent misrepresentation that the fiscal
1992 and 1993 audits were materially accurate, and were conducted
in compliance with GAAS. The Wagoner rule does not necessarily govern CBI's negligence
claims, because the right to sue for fraud and the right to sue
for negligence inhere in different entities. As already
explained, under New York law as stated in the Wagoner rule,
where a third party defrauded the corporation with the
cooperation of management, the right to sue the third party for
fraud generally accrues to the creditors, not to the corporation
itself. By contrast, where a third party has committed
negligence, the right to sue the third party for that negligence
accrues to the corporation itself. See, e.g., Sec. Investor
Prot. Corp. v. BDO Seidman, LLP, 95 N.Y.2d 702, 711-12 (2001);
Credit Alliance Corp. v. Arthur Andersen & Co., 65 N.Y.2d 536,
551 (1985). Indeed, under New York law, a negligence claim
against an accountant belongs only to the corporation-client,
except where there is sufficient privity between the accountant
and a third party, non-client (e.g., a creditor of the client).
Id. (setting forth standard for cause of action by third party
against accountant). Accordingly, the right to sue Ernst & Young
for any negligence belonged to CBI and to any third party
creditor with sufficient privity to Ernst & Young.

The question arises whether CBI's committing the fraud strips
it of standing to sue Ernst & Young for negligence. There is some
support for the proposition that CBI lacks standing to sue Ernst
& Young for its negligence, due to CBI's own fraudulent actions.
For example, in Cenco, Judge Posner reasoned that "breach of
contract, negligence, and fraud, when committed by auditors, are
a single form of wrongdoing under different names." Cenco, 686 F.2d at
453. Based on that reasoning, Judge Posner found that a company
that lacked standing to sue its accountant for fraud (on the
ground that the company itself was involved in the fraud) also
lacked standing to sue its accountant for negligence.

The Second Circuit has adopted a more expansive view than that
articulated in Cenco of the circumstances in which a company
has standing: A bankruptcy trustee has standing to assert claims
other than fraud claims against a third party where the facts
giving rise to those claims are distinct from any facts
concerning any participation by the third party in management's
fraud. That standard is supported by the logic underlying both
Wagoner, 944 F.2d 114, and Hirsch, 72 F.3d 1085. In
Wagoner, the Second Circuit found that, although the bankruptcy
trustee could not sue the company's broker for fraud, the trustee
could sue the company's broker in contract for churning the
company's account. Wagoner, 944 F.2d at 119. Wagoner's
finding was based on the fact that churning may form the basis
for a cause of action in contract, and that the broker's alleged
churning was "clearly distinct" from the broker's alleged
participation in management's fraud. See Hirsch, 72 F.3d at
1094 n. 6 (discussing Wagoner's finding that the trustee had
standing on the churning claim). Accord Wagoner, 944 F.2d at
119. By way of contrast, in Hirsch, the allegations giving rise
to the malpractice claim (which was not based in fraud) were
"closely tied" to the allegation that defendants had participated
in management's fraud. Hirsch, 72 F.3d at 1089-90 & 1094 n. 6.
Thus, the Hirsch court held that the trustee lacked standing to
bring the malpractice claim on behalf of the company against the
defendant accountants and law firms.*fn15 See also In
re Bennett Funding Group, 336 F.3d at 100 (applying the
Wagoner rule to bar the trustee's professional malpractice
claims, where the third-party professionals were allegedly
complicit in the fraud). Even so, the Hirsch court recognized
that if the trustee could establish "some independent financial
injury to the [debtor company] . . . as a result of the alleged
professional malpractice," the trustee could have standing to sue
a third party on a claim other than fraud, even where the trustee
lacked standing to sue for fraud. Hirsch, 72 F.3d at 1094.

Applying that standard here, the Court finds that the
allegations giving rise to CBI's claims premised on negligence
are clearly distinct from the allegations premised on
management's fraud. BSI here does not allege that Ernst & Young
participated in the fraud perpetrated by CBI's culpable
officials. Indeed, BSI does not dispute that those officials
attempted to conceal the fraud from Ernst & Young. Rather, BSI
alleges that Ernst & Young is independently at fault for
committing errors in auditing CBI. According to BSI's negligence
claims, a reasonable accountant would not have made the auditing errors that Ernst & Young made, even
if the culpable CBI officials had tried to hide their fraud from
that (reasonable) accountant. BSI thus has asserted that CBI was
injured (in a legally cognizable way) by Ernst & Young's
performance of the audits. Accordingly, BSI has standing to
assert CBI's claims for negligence.*fn16

The Court's conclusion that BSI has standing to assert CBI's
negligence claims (despite the fact that CBI contributed to its
own injuries) is consistent with New York law. New York law
employs a comparative negligence analysis, in which a plaintiff's
contributory fault (e.g., CBI's fraud) does not bar the
plaintiff's recovery against a defendant who caused some of the
plaintiff's injuries. N.Y.C.P.L.R. § 1411; 1A Pattern Jury
Instructions 2:36 intro. stmt. (3d ed. 2004). Rather, under New
York's scheme, the recovery accorded to a plaintiff that is
partially at fault for its own injuries may be diminished in
proportion to the plaintiff's fault. See id.; 1B Pattern Jury
Instructions 2:154 cmt. (3d ed. 2004). See also Hall & Co.
v. Steiner & Mondore, 147 A.D.2d 225, 227-28 (N.Y. App. Div.
1989) (plaintiff alleging accountant malpractice for accountant's failure to discover irregularities
purposely made in plaintiff's books is subject to
accountant-defendant's affirmative defense of culpable or
negligent conduct); Craig v. Anyon, 212 A.D. 55 (N.Y. App. Div.
1925) (same). Thus, under New York law, the fault imputed to CBI
as a result of management's fraud does not bar CBI's claims for
negligence, and BSI has standing to assert those claims on behalf
of CBI.*fn17

c. CBI's Contract Claims

There can be no question that, if CBI's management had not
defrauded the company, New York law would accord CBI the right to
sue Ernst & Young for the alleged breach of contract. The
allegations giving rise to the claims for contractual breach are
analogous to the allegations giving rise to the claims for
negligence. Based on the logic articulated above with respect to
the negligence claims, the Court finds that BSI has standing to
assert CBI's claims for breach of contract.

2. Standing to Assert TCW's Claims

In addition to asserting the above claims on TCW's behalf as a
shareholder of CBI, BSI asserts claims for fraud and negligence
as assignee of TCW's claims made in TCW's capacity as creditor.
As explained above, "a claim against a third party for defrauding
a corporation with the cooperation of management accrues to
creditors. . . ." Wagoner, 944 F.2d at 120. Accordingly, TCW,
as a creditor of CBI, has standing to assert fraud claims against
Ernst & Young.

With respect to TCW's claims for negligence, under New York
law, an accountant generally cannot be held liable to third
parties for the negligent performance of an auditing contract
between the accountant and his client. See Security Pac. Bus.
Credit, Inc. v. Peat Marwick Main & Co., 79 N.Y.2d 695 (1992);
Credit Alliance Corp. v. Arthur Andersen & Co., 65 N.Y.2d 536
(1985). However, a negligent accountant can be held liable to a
third party if: (1) the accountant was aware that his financial
reports were to be used for a particular purpose; (2) a known
third party was intended to rely on the financial reports in
furtherance of that purpose; and (3) some conduct on the part of
the accountant links the accountant to the third party and shows
that the accountant understood that the third party relied on the
accountant. Id. at 551. These "indicia, while distinct, are
interrelated and collectively require a third party claiming harm
to demonstrate a relationship or bond with the once-removed
accountants. . . ." Security Pacific, 79 N.Y.2d at 702-03.

Applying this test (the "Credit Alliance test"), the
bankruptcy court here concluded that the relationship between
Ernst & Young and TCW sufficiently approached actual privity for
TCW to have a claim against Ernst & Young. In re CBI Holding,
247 B.R. at 365-66. Given that the Court has concluded that Ernst & Young has
a right to a jury trial with respect to TCW's claims, the
disputed facts pertaining to the Credit Alliance test must be
put before a jury.*fn18 The Court thus reverses the
bankruptcy's court's determination that BSI possessed standing to
assert TCW's negligence claims.

D. Affirmative Defense (against TCW's claims)

Ernst & Young contends that BSI is precluded from asserting
TCW's claims under New York's General Obligations Law, which
provides that "[a] tortfeasor who has obtained his own release
from liability shall not be entitled to contribution from any
other person." N.Y. Gen. Oblig. L. § 15-108(c). Under the Plan,
TCW obtained a release from liability to CBI and to CBI's other
creditors for TCW's role, if any, in CBI's demise. See RE 799a
(releasing TCW "from any and all claims"). Pointing to that
release, Ernst & Young asserts that TCW cannot now seek
contribution from Ernst & Young. New York law defines the term
"contribution" as a claim that may be made among two or more
persons who are "subject to liability for damages for the same
. . . injury to property. . . ." N.Y.C.P.L.R. § 1401. The Court finds that TCW's claims against Ernst & Young are not
claims for "contribution" because those claims do not arise from
the "same injury" as the injuries for which TCW obtained a
release. TCW obtained a release from any liability arising out of
the injuries to CBI and to CBI's other creditors. TCW does not
now seek contribution from Ernst & Young concerning those
injuries. Rather, TCW seeks damages for the injuries suffered by
TCW itself. TCW's injuries are factually related to the injuries
suffered by CBI and by CBI's other creditors, but TCW's injuries,
nevertheless, are separate and distinct. See, e.g.,
Cresswell v. Warden, 164 A.D.2d 855, 856 (N.Y. App. Div. 1990)
("It is the fact of liability to the same person for the same
harm . . . which controls.") Accordingly, Ernst & Young's defense
against TCW under New York's General Obligations Law, §
15-108(c), is misguided. See, e.g., Nassau Roofing & Sheet
Metal Co. v. Facilities Dev't Corp., 71 N.Y.2d 599, 604 (1988)
(no claim for contribution where injuries are separate and
distinct).

IV. Conclusion

For the reasons stated above, the Court reiterates its previous
holding that all of the claims in this action are core, and
further concludes: (1) that Ernst & Young has a right to a jury
trial on TCW's claims as a creditor; (2) that BSI has standing to
sue Ernst & Young for negligence and breach of contract on behalf
of CBI, and for fraud on behalf of TCW as a creditor; and (3)
that TCW is not precluded from suing Ernst & Young under N.Y.
Gen. Oblig. L. 15-108. The Court therefore vacates the judgment of the
bankruptcy court with respect to the claims asserted by BSI on
behalf of TCW in its role as a creditor.

The Court does not now resolve whether BSI has standing to sue
Ernst & Young for fraud on behalf of CBI, or negligence on behalf
of TCW as a creditor. Nor does the Court now resolve the other
issues raised on appeal, some of which are rendered moot by the
Court's conclusion that Ernst & Young is entitled to a jury trial
with respect to TCW's claims.

The Court orders the parties to submit a proposed briefing
schedule to address the question of whether the Court's
conclusion that Ernst & Young is entitled to a jury trial with
respect to TCW's claims necessitates a new trial on CBI's claims
as well. The Court notes that the only briefing on this subject
to date is contained in a single paragraph in Ernst & Young's
reply brief. See Reply Brief of Appellants Ernst & Young, Ernst
& Young LLP, at 5.

SO ORDERED.

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